By Tiernan Ray

Shares of Facebook (FB) are down 46 cents, or 0.7%, at $67.60, regaining some ground after losing as much as 5% at one point last night after the company said it will pay $19 billion in a combination of stock and cash to purchase real-time messaging service provider WhatsApp.

On a conference call last night, Facebook CEO Mark Zuckerberg offered no details about revenue or other financials for WhatsApp. Instead, he said that he expects the service, which has around 450 millionmonthly average users (MAUs), to hit a billion users in future, and said Facebook will be careful not to change the service, and won’t pursue advertising as a means to monetize the service. Some WhatsApp users pay a yearly fee of 99 cents to use the service, though new users are immediately offered a free year of usage.

There’s a tension today between the large price tag and those who see a reasonable price for each of those monthly users.

Some see the deal as bringing Facebook a whole new future, with WhatsApp being equivalent to the entire global text messaging traffic. Others think the deal is primarily defensive, meant to ensure Facebook doesn’t become irrelevant with WhatsApp’s primary audience of teens.

Most analysts don’t seem very worried about the dilution that will come from the deal.

There were two downgrades of Facebook today, one from Evercore Partners’s Ken Sena, who cut the stock to Equal Weight from Overweight, and one from Pivotal Research Group’s Brian Wieser, who cut his rating to Hold from Buy.

Sena writes that Facebook’s “cost of delivering increased engagement is higher than we are comfortable with,” as a result of the service having a problem of slower adoption among 18- to 24-year-olds:

By examining mobile demographic engagement data through comScore, we find that engagement among FB youth ages 18-24 is increasing consistent with its broader demos. However, growth in these younger users is lagging other age demos. Moreover, when we index the engagement of youths to all ages on the platform, FB youths under-index peers and, surprisingly, even the Internet overall (although this is as much due to older demos over-indexing on FB one can certainly argue) […] For a sense of scale, we show the total domestic mobile unique visitors (ages 18-24) in 4Q across these experiences. Facebook, excluding Instagram, is at 19 million compared to the total mobile internet’s 24 million, Instagram’s 11 million, Twitter’s 9 million, and Tumblr’s 7 million […] On the basis of mobile minutes per mobile unique visitor among social media platforms, FB roughly doubles the next largest experience, Instagram, which it obviously owns. This is followed by Twitter and Tumblr. Essentially, what this data shows is that while youths spend roughly a half hour per day on Facebook, they spend just about half that amount of time on Instagram, and even less on Twitter and Tumblr […] On a per user basis, growth in Facebook’s youth demographic has essentially stalled and even turned negative in September through November, declining 6% y/y in each month, though it did recover to roughly flat y/y in December […] Facebook’s percentage of total time spent among 18-24 year olds in December 2013 is actually the lowest at 19%. This compares to Tumblr’s 74%, Twitter’s 50%, Instagram’s 48% and even the total mobile internet is higher at 21%.

While Facebook has a lot of downloads on mobile devices, including Apple’s (AAPL) iPhone, and on Google’s (GOOG) Android platform, nevertheless, the chat apps such as WhatsApp have been on fire:

On Google Play, though Facebook led in downloads for the three months October- December, Facebook Messenger and WhatsApp followed in second and third, with Instagram in sixth, ahead of both Twitter and Tumblr with 35 million downloads […] Similarly, on iOS, while Instagram led with over 18 million downloads during the fourth quarter, WhatsApp and Facebook Messenger again came next, with Twitter and Facebook in fourth, each with roughly six million total downloads, respectively.

Sena’s bottom line is that the deal shows Facebook’s having to fight the slowing among that youth demographic by paying up in a hefty way to keep building traffic:

FB agreed to pay ~$42 per WhatsApp user even though WhatsApp generates $0.99 per year per user (after the first year), suggesting a decades-long payback under WhatsApp’s current business model, should new user growth slow. Moreover, Viber, a competitive alternative to WhatsApp with roughly two-thirds the scale and comparable growth sold to Rakuten recently for $900mm.

Wieser writes that “While we see strategic merit, the acquisition is difficult to justify on metrics we use to value Facebook.”

To justify $19bn, WhatsApp would need to generate around $1bn in annual cashflow by our model ‘s terminal year of 2018. However, few data-points to support such an assumption were provided by the company, as evidently few are available. As management indicated, it expects WhatsApp to focus on product and users rather than monetization, anyways. Conceptually, we agree with this notion given the sudden scale that WhatsApp achieved. Still, investors in Facebook will want to justify the valuation of such a transaction. On our own (crude) estimates, if we assumed the product had an average of 1bn users next year and added 100mm per year, with 25% of the user base at that time paying $2/year (we would assume many users will simply never pay, shifting devices and/or services as needed, while those who will pay might be willing to pay more than the current $1/year level), we could arrive at $650mm in revenue. $1bn is possible, but given the optimism already incorporated in a $650mm figure, it might seem a stretch.

Elsewhere, Susquehanna Financial Group’s Brian Nowak reiterates a “Positive” rating on Facebook, writing that the price tag wasn’t that much more than what Google paid for YouTube:

This isn’t the first time a large online platform has paid up to protect its core business’ long-term trajectory (and add new functionality). We’ve seen it out of Google before ($1.65bn for YouTube, $12.5bn for Motorola, and most recently, $969mn for Waze). $19bn is admittedly a hefty price tag, but $42 per WhatsApp user is only 9% higher than what Google bought YouTube for. It is 14% more than Facebook paid for each Instagram user. Those acquisitions seemed pricey at the time of the deals too, but they are now key parts of the Google and Facebook ecosystems and monetization stories (which trade at much higher multiples in the public markets).

He sees minimal dilution:

There’s no denying this deal will be dilutive, as we estimate it will impact our ’15 EPS estimate by 5% (See Fig 4). The largest drivers of the dilution are the incremental shares to be issued in the transaction. Note that in our dilution analysis we assume that WhatsApp grows to ~745mn users at the end of 2015 and that an average of 35% are paying customers in 2015 (which may prove conservative given the high engagement and growth of the $0.99 app market). The high incremental margins of the messaging business (we estimate to be 80%) will give cushion to the dilution.

Nomura Equity Research’s Anthony DiClemente reiterates a Buy rating on the stock, and a $78 price target, writing that there are three good reasons for the deal, despite the large ticket size:

In the end, we believe FB’s acquisition of WhatsApp is defensible for three reasons: 1) Strategy: WhatsApp is an asset that unquestionably strengthens Facebook’s strategic position in social / mobile communication; 2) Growth: WhatsApp’s growth has been incredibly rapid, as it possesses 450m monthly users, adding 1m users a day; and 3) Valuation: WhatsApp’s valuation, when viewed through the prism of other networks that have achieved scale (namely Twitter) is not entirely unreasonable on a per user basis.

And the valuation is not unreasonable:

We use two rough valuation frameworks: 1) In terms of valuation, FB is paying ~$42 per user, which compares to $131 for TWTR, $30 for Instagram (at the time of its acquisition), and $50 for Skype (at the time of its acquisition); and 2) Assuming WhatsApp can grow to 1bn users paying $1/year, this would equate to $900mn in EBITDA, or $19.4bn at FB’s 2015E EV/EBITDA multiple.

Wedge Partners’s Martin Pyykkonen, who doesn’t have a formal rating on Facebook stock, writes that the deal is “Reminiscent of Early Stage Internet/Tech Deals With Big Stock Currency.”

Facebook can afford the deal, and the dilution to the company is likely to be less than 10%, he writes, but the payoff is uncertain given the challenges to monetizing WhatsApp:

We think FB’s acquisition of Instagram is showing early signs of fruition, but this deal for WhatsApp has a lot more long-term uncertainty in terms of monetization and financial payback. We understand FB’s motivation to create competitive moats in mobile apps like real-time messaging, but from an investor perspective we think there would be challenges for a high growth and high margin subscription model. From a user perspective, WhatsApp is probably a no-brainer for foreign messaging traffic (avoiding foreign cross-border SMS-like fees and paying only relatively little for message units used), but that doesn’t necessarily build a strong financial model for a new service provider or enabler. Any traditional stock valuation approaches are really irrelevant (minimal revenue, no focus near term on revenue growth or establishing profitability anytime soon) at this point. The key to success can only be measured longer term and we think it will come to down to an overall fairly simple point, e.g., whether WhatsApp can sustain its phenomenal recent growth, and even more importantly whether WhatsApp can sustain a competitive lock and be a de facto standard on its core business thus far (mobile real-time messaging), with eventually a lot of “real-time” monetization. Yet even with the lack of valuation parameters and the size of this deal, the economics for FB aren’t as “expensive” or onerous on the stock as they seem at first glance – that is if they are really picking the right winner for the long term. FB’s deal is heavily tilted (75%) to its stock, and it has a compelling stock currency with just setting a new all-time high and being on a path to a ~2x return since its IPO just under two years ago (`3x return if including the initial post-IPO downdraft on the stock).

Morgan Stanley’s Scott Devitt reiterates an Overweight rating on Facebook stock, and a $72 price target, calling out at the top of the note Facebook’s own observation that “Facebook noted that WhatsApp is the only service it has discovered that has greater daily engagement than Facebook itself).”

Despite Zuckerberg’s focus on the 1-billion user mark, “Facebook is not yet able to quantify the overlap with its own 1.23b users.” He thinks other messaging services, such as China’s Tencent Holdings (0700HK) may point the way:

We look to mobile messaging leaders such as Tencent for clues, acknowledging that Facebook may be able to layer a suite of value-added services on top of WhatsApp’s user base over time. We adjust our model to include the $4b cash outflow and 230m share dilution as of 4Q2014, although the transaction may close sooner. We calculate an approximate 2% dilution to EPS.

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